Changhua Chemical Technology's (SZSE:301518) Solid Profits Have Weak Fundamentals

Changhua Chemical Technology Co., Ltd.'s (SZSE:301518) stock was strong after they recently reported robust earnings. However, we think that shareholders may be missing some concerning details in the numbers.

See our latest analysis for Changhua Chemical Technology

A Closer Look At Changhua Chemical Technology's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Changhua Chemical Technology has an accrual ratio of 0.21 for the year to December 2023. Unfortunately, that means its free cash flow fell significantly short of its reported profits. To wit, it produced free cash flow of CN¥12m during the period, falling well short of its reported profit of CN¥116.1m. Changhua Chemical Technology shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. The good news for shareholders is that Changhua Chemical Technology's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Changhua Chemical Technology.

Our Take On Changhua Chemical Technology's Profit Performance

Changhua Chemical Technology didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Because of this, we think that it may be that Changhua Chemical Technology's statutory profits are better than its underlying earnings power. But at least holders can take some solace from the 40% per annum growth in EPS for the last three. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. If you want to do dive deeper into Changhua Chemical Technology, you'd also look into what risks it is currently facing. For example, Changhua Chemical Technology has 2 warning signs (and 1 which is potentially serious) we think you should know about.

Today we've zoomed in on a single data point to better understand the nature of Changhua Chemical Technology's profit. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.